SPIA The Good Annuity

How “The Good Annuity” Works in an IRA

The Good Annuity and IRAs


Single Premium Immediate Annuities (SPIAs) are the so-called “good annuity.”

You can buy the good annuity either after-tax (in your brokerage account) or with pre-tax (such as IRA) retirement savings. With the after-tax SPIA, some of the income is taxable depending on the exclusion ratio. With a pre-tax SPIA, all of the income is always taxable!

Before we get too far into the weeds, why is a good annuity good? Do you want to consider an IRA SPIA?


Why is the Good Annuity Good?

Single Premium Immediate Annuities are NOT like the other annuities on the market.

This is not a Variable Annuity which is expensive and complicated.

This is not an indecipherable Fixed (or Equity) Indexed Annuity with non-guaranteed caps and participation rates.

SPIAs are simple! You, in exchange for a lump sum of money, get a lifetime income stream.

In essence and in fact, SPIAs allow you to buy a pension.

They are so simple and easy, that the insurance “advisor” doesn’t sell them because the commissions are low. It is said that annuities are sold not bought. That is true for most annuities, but not SPIAs!

Consumers want SPIAs because they are the good annuity. They are bond replacements in your asset allocation. But to truly understand what makes a Single Premium Immediate Annuity the good annuity, you must understand mortality credits.


Mortality Credits make SPIA the Good Annuity

Without being too morbid, we are all going to die! Insurance companies know that, and they take advantage of that fact. They actually play both sides of that coin.

Insurance companies sell life insurance which pays out when someone dies. On the other side of the coin, they sell annuities which STOP paying out when someone dies! So, insurance companies can hedge their life insurance bets with annuities. Or, hedge their annuity bets with life insurance.

When SPIAs sell, they are placed in a “risk pool.” The actuaries know how many people are going to die each and every year in that pool. They don’t know who is going to die, but they know how many people in the risk pool die.

When you buy a SPIA, you get mortality credits because the insurance company knows they will pay less and less each and every passing year. People die; the living keep getting income.

Yes, insurance companies use bonds to cover their liabilities on the good annuity. DIY investors say they can get the same returns as SPIAs because they will just buy the same bonds. But the fact is DIY investors don’t have risk pools; they don’t get mortality credits!

Mortality credits are increased payments that everyone gets because the actuaries know that some people in the risk pool will die off every year. You get paid more (even initially) because the money is at risk.


The Good Annuity’s Largest Downside

And that is the good annuity’s largest downside. Your money is at risk.

If you die, the lump sum you turned into income dies with you!

Folks can’t seem to get over that fact, which leads to the annuity puzzle.

I want you to recognize that loosing your money when you die is a good thing! Seriously, it is what give you mortality credits and an increase in payment ABOVE what you can get from bonds! As you survive longer than the actuaries expect you too, you continue to benefit from the higher income that similar bonds alone can provide. All because of mortality credits.


An Example of a SPIA in an IRA

Let’s look at the Good Annuity in an IRA. You can transfer your retirement money into a SPIA at an insurance company. This is called an Individual Retirement Annuity.

Consider a single male aged 65 who desires lifetime income. He has social security, $500k in a brokerage account, and a $1M IRA.

He is smart so he avoids expensive, complicated Variable and Fixed Indexed Annuities. Instead, he desires to have secure, guaranteed, lifetime income and is looking at a qualified SPIA.

What happens if he invests a quarter, half, three quarters, or all of his IRA into a SPIA?


Lifetime Income from an IRA SPIA

First, how much income will he receive?

Lifetime Income from IRA SPIA

Figure 1 (Lifetime Income from IRA SPIA)


Income in retirement is important! Let’s see what $250k or $1M can buy for lifetime income with a SPIA.

Purple represents stable income from social security. Annuity income is in mauve, and withdrawals from the IRA are in orange.

His social security is $24,000 a year and has a cost of living adjustment indexed to a measure of Consumer Price Index. About 24% of his retirement income goals are met from social security.

The $250k SPIA on top adds $17,000 a year, an amount which is not cost of living adjusted. Now, about 36% of the income is stable.

For the $1M SPIA, $68,000 a year is paid and 70% of the income is stable.

Assuming his inflation is 2% per year, you can see the withdrawals slowly increase over time. It is important to note the withdrawals are quite small in the beginning, giving time for the tax-deferred investments to grow to meet the future income demands!

In addition, his income will never fall below 36% or 70% of his “needs,” which is important. In this case, needs include both floor expenses (rent, food, gas, electricity etc.) and desired spending goals (such as eating out, travel, etc.). Spending in retirement is lumpy, and usually goes down over time aside from health care need which tend to spike in the very late years.

Some of you are probably looking at the increasing income needs over time and wondering how he is going to afford all those withdrawals and a SPIA. Well, what effect does the purchase of a SPIA have on his portfolio value?


Visualizing Total Portfolio Value with a SPIA

Let’s look at the value of his portfolio with and without SPIA in the IRA. We know he had a $1M IRA in addition to $500k in a brokerage account to start.


Portfolio value IRA SPIA)

Figure 2 (Portfolio value after an IRA SPIA)


Above you can see the total value of the portfolio over the years.

On top, a $250k IRA SPIA is demonstrated in green vs. no SPIA in lime. With the initial purchase, the portfolio value drops by $250k. Note, however, over time that the SPIA pays off as there are less withdrawal from his investments. The ending portfolio values are nearly identical after 35 years.

On the bottom, $1M is spent on an IRA SPIA. In this setting, given the stable income from the SPIA, the portfolio value actually increases over time! This is because the withdrawal rate on the remaining portfolio is small, so the remaining investments grow more rapidly.

Over time, despite 2% inflation, there is almost no decrease in his portfolio size over time. This is good to know as some folks are worried about legacy if they use a SPIA. In this example, you pretty much know how much you have to leave behind with a SPIA.

Many people want to leave behind a legacy. In fact, that is a large issue in the annuity puzzle; let’s look at it more closely.

If you buy a SPIA, how much will you leave behind? Probability distributions can help answer that question.


Probability Distributions of Single Premium Immediate Annuities


Good Annuity in IRA

Figure 3 (Probability Distributions of SPIAs)

Again, on top is $250k IRA SPIA and $1M on the bottom.

The blue line demonstrates the average expected return of remaining assets. In dark blue, 25-75th percentile, and 5-95th percentile in light blue.

On the top, there is a small dip and the expect amount decreases to zero after 35 years. With the larger initial outlay in the $1M IRA SPIA, the line initially slopes up before slowly decreasing. In fact, there is the expectation of money remaining after 35 years. Stated explicitly, a large SPIA is more likely to leave a legacy after 35 years than a small one! That seems counterintuitive.

The 25%-75% confidence levels are dark blue. On the low side, this runs out of money at 94 and 97 years. On the upside, there is about $1M remaining portfolio balance in each plan.

The potential upside of staying invested in the market is seen in the 5%-95% confidence levels in light blue. Here, you may have $3.5M left with the smaller SPIA, and $2.5M left with the larger. The downside: you might run out at 86 or 92 years of age.

You can see that there is more upside potential with a smaller SPIA, as there is more market risk. If the market does well, your heirs do well as you have more assets left to chance in the market. However, a smaller SPIA has more downside risk, and counterintuitively, you are more likely to leave assets behind with a larger rather than a smaller IRA SPIA.

Does that solve the annuity puzzle? I doubt it!


Tax Considerations of IRA SPIAs

Let’s move on to taxes!

There are always tax considerations with annuities. This is especially true when required minimum distributions come due.


Tax considerations of IRA SPIAs

Figure 4 (Tax considerations of IRA SPIAs)


Let’s look more closely as to why there are more taxes with a Single Premium Immediate Annuity in an IRA.

In green, find yearly tax payments with just social security. You can see they are low until required minimum distributions kick in at 70. At 71, there is another small bump when The Tax Cut and Jobs Act expires. Over time, taxes increases with required minimum distributions. Eventually they slow down as the distributions eat away at the IRA balance.

With a $1M IRA SPIA (blue), initial taxes are higher as the income from the SPIA is fully taxable. SPIAs from pre-tax accounts (such as IRAs and 401k) are always fully taxable. Taxes stay flat over time, as the income from the IRA SPIA satisfy the required minimum distributions.

What are the expected Required Minimum Distributions for each account? Initial RMDs at age 70 are:

  • Social security: $45,000
  • 250k SPIA: $33,800
  • 500k SPIA: $22,500
  • 750k SPIA: $11,200
  • 1M SPIA: none

So, SPIAs do decrease RMDs but overall, there is an increase in tax liability, especially early.

There must be additional advantages to a SPIA? Let’s look at sequence of return risk and income.


IRA Annuities in the Setting of Sequence of Return Risk

Sequence of Return Risk and IRA SPIA

Figure 5 (Sequence of Return Risk and IRA SPIA)


The greatest risk in retirement is Sequence of Returns Risk (SORR). I have described SORR in detail previously.

Let’s see what happens if a sequence similar to 2000-2010 happens again at the worst time, right at retirement.

Above, see the effect a $250k IRA SPIA (top) and $1M IRA SPIA (bottom) have with Sequence of Return Risk. For both, the light green is social security without any SPIA.

With the small SPIA, there is very little dampening of volatility of SORR. There is minimal benefit as well and the portfolio expires an additional year after social security. Of course, social security continues for both. Social security starts at $24,000 a year and has inflation adjustment. With the SPIA, you get an additional $17,000 of floor income for the rest of your life as well.

With the large SPIA, there is much less volatility during SORR. Indeed, as you need to withdrawal less from your investments during the down years, the income value actually drifts slightly up. After that, with the stable floor income, there is very slow decline in the portfolio value. When the portfolio expires at age 100, you are left with social security and $68,000 SPIA payment for the rest of your life.

Let’s review and decide if a Single Premium Immediate Annuity in your IRA is a good idea or not.


Summary Table for the Good Annuity and IRAs


single premium immediate annuity the good annuity

Figure 6 (summary table Good Annuity and IRAs)

Above, you can see the summary table.

Baseline means no Single Premium Immediate Annuity. Below that: the amount used to purchase an IRA SPIA from $250k up to $1M.

As you can see, Monte Carlo odds increase the more money you use to purchase a Single Premium Immediate Annuity.

The yearly Annuity income amount is next. This Annuity is 6.8% yearly income. The return percentage is from an online annuity website obtained for an IRA SPIA on a single 65 year old male.

Social security and the IRA annuity provide stable (or floor) income. You see just with social security, about 24% of the income is stable. A $250k IRA SPIA adds 11.7%, while a $1M SPIA adds 46.4% of stable income. This means $1M provides more than 70% of his expected lifetime income.

Lastly, an IRA Single Premium Immediate Annuity means more taxes owed. See the increase in taxes above the baseline above.


Conclusion: Single Premium Immediate Annuity in IRAs – The Good Annuity

Well, what did we learn?

Qualified Single Premium Immediate Annuities are SPIAs in your IRA. When you transfer funds from your qualified accounts (IRAs and 401k) to an insurance company, you can purchase a qualified annuity.

SPIAs in IRAs can improve the chances of success in your retirement. Even if you run out of nest egg, SPIAs provide ongoing, guaranteed income while you are alive.

In addition, not uncommonly you have even more of a legacy with a SPIA than without! While folks are worried about irrevocably “giving” away their money in exchange for purchasing a pension, it is not uncommon for their heirs to be better off. In addition, a SPIA in an IRA may protect against Sequence of Return Risk.

Taxation is an issue. Single Premium Immediate Annuities from qualified (pre-tax) sources are always taxable. This can have implications on taxation of social security and may cause issues with the tax torpedo.

In the end, you can use pre-tax money to buy an income stream. This income can cover your floor or fixed expenses. These expenses don’t go away with time, and neither does the income from your IRA SPIA.

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  1. So is it an oversimplification to consider that we are comparing two separate needs? One need is to not run out of money and the other need is to leave as much money as possible to inheritance. If this asumption is correct then my concern for running out of money is greater than becoming dependent on my children so I should consider a large sum deposited into an annuity and hope I live long enough so that the inheritance I leave will actually be equivalent to or larger then not having started out with an annuity. Am I thinking correctly?

  2. Yes, that is one way to look at it. But longevity vs liquidity is another way. If you have an emergency expense you can’t meet early on, that is not idea either. And there is always the inflation concern…if you lock up your money, you might not have a chance in a hyperinflationary environment, but if it is bad enough it would be hard to make anything work. Tradeoffs, as are all financial investing decisions.

  3. If one dies on Day Two of the “35 year plan”, what is the “loss” to the heirs compared to no SPIA? And at what point along the 35 year plan does this amount cross over into the positive, i.e., the heirs actually have more than without the SPIA? If the average life expectancy of a 65 yo male is 83 years, what percentage of all heirs are “winners”? I see the hard numbers on best-case scenario (surviving to 100), but what are the results for “average-case scenario”, surviving to 83?

    • Thanks for the comment. If you die on day two, the loss is the amount that you put into the SPIA!

      Otherwise, see figure 3 or go back a couple blogs for my last post on Good Annuities and you can see the cross over point.

      But again, the point is income and some longevity protection rather than legacy!

  4. Not to be a whiner, because I love your posts and share them with my much younger physician offspring, but some of my questioning was rhetorical, and you do emphasize, “you have even more of a legacy with a SPIA than without!” without a more clear context of probability or an equally enthusiastic, “You may pay $1,000,000 and have even less of a legacy with a SPIA than without!”. To the degree that SPIA is guaranteed and safe, the best analogy I see is that you are buying a privatized Social Security account, (to the degree that Social Security is guaranteed and safe!). That may be the best strategy for some, and the worst, or at least unnecessary, for others. Frustratingly, it is impossible to know prospectively which option is the best for any given individual. Thus my emphasis on reporting the results for “average-case scenario”, surviving to 83, rather than touting the power of this plan if living to 100.

    • I agree. I guess I would get back to the idea that if you want some income from your retirement account, then you are better off using a SPIA rather than bonds due to mortality credits. If you don’t live longer than the actuaries think you will, then you may still be better off if you adjust your asset allocation to be more aggressive given that you have the bond-like SPIA. So, you may well be better off being 80/20 with a SPIA rather than 60/40 without one if the markets do well, even if you live to less than 83!

      Just a lot of moving parts and you have to stop making assumptions at some point. And fundamentally, these are insurance products rather than investments. You risk pool for longevity. If you want your kids to have a guaranteed inheritance, there is a way to do that too!

      Thank for the conversations!

  5. Another great post, David. Thanks.
    I like the idea of SPIAs as the best way to address longevity risk. Using them also to address SORR requires them to be purchased pretty early. What do you think about the idea of using a bond tent to deal with SORR for the first 10 years of retirement, and then convert that bond percentage into a SPIA at age 75 or 80 when the size of the single premium required will be much less? I think this is the strategy that the “Retirement and IRA” podcast guys recommend.

    • Smart. There is a lot to like about not locking up the money right now (in a DIA) and instead staying flexible until you need the income (with a SPIA you buy later).

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